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Best ETF Strategies to Consider Now

The minutes of the FOMC meeting released last week suggested that the central bank is likely to maintain its accommodative policy stance in foreseeable future, even after it winds down its asset purchase program. With waning rate hike worries, stocks are likely to continue their slow, upward march.

Economic data in general has been surprising to the upside of late, indicating that the economy gained momentum in the second quarter after coming out of the deep freeze earlier this year. At the same time, while the labor market is improving, wage pressures are missing, suggesting that the Fed will not be in a hurry to change its monetary stance. (Read: 3 Impressive Mid Cap ETFs to Buy Now)

What Surprised in the First Half

Most analysts had predicted that interest rates will creep up as the Fed gradually winds down its massive support. But interest rates plunged lower, puzzling most analysts and investors. With decline in yields, bonds returned to profits after making losses last year. That situation may reverse soon if interest rates start inching up, which looks possible now particularly in view of rising inflation worries.

Low interest rates also proved to be a blessing for emerging markets. With the start of taper talk, foreign investors had rushed for exits leaving EM stocks and the currencies in a downward spiral. The trend reversed this year with investors returning to emerging markets as they realized that interest rates in the developed world were not going up as earlier feared. (Read: Dividend Boom and Share Buybacks Put these ETFs in focus)

Now let’s look at what may happen in the second half.

Stocks Still Remain Attractive

Most stocks are not cheap now but they are not outrageously expensive either and they still remain attractive due to lack of any better alternative. A brightening economic picture and low interest rates are great for stocks and so I would not be surprised to see stocks moving higher from here. Investors’ optimism may get a boost if Q2 earnings and management guidance improve from the previous quarters.

Top Sectors for the Second Half

With the economy picking up momentum, I like Technology, Industrials and Energy sectors. Technology sector had remained mostly out of favor with investors due to less-than supportive global macroeconomic environment. Pick-up in the global economy and business spending will benefit the sector. (Read: 3 ETFs to Cash in on Aging Global Population)

Per Zacks Earnings Trends, total earnings for the sector are expected to be up 6.4% from the same period last year on 4.7% higher revenue. Continued improvement in the manufacturing activity bodes well for Industrials.

Rising geopolitical stress has pushed energy prices up this year, resulting in energy stocks’ outperformance during Q2 and while the prices have softened of late, the sector still looks attractive. Per Zacks estimates, Oil/Energy sector is likely to see earnings
growth of 8.1% for Q2.

Record low yields were supportive for defensive sectors during the first half but they now look quite expensive considering their growth potential.

Prepare for Higher Volatility

Markets have remained unusually calm so far this year but investors should prepare themselves for more twists and turns in the coming months. Mid-term elections and speculations over the timing of Fed’s rate hike may lead to some turbulence. And the possibility of pullbacks remains high.

Academic studies have shown that in long term, the performance of an investment portfolio depends mostly (some studies suggest ~ 90%) on asset allocation, i.e. how an investor allocates money among major asset classes and well-diversified portfolios always results in better risk-adjusted returns. Diversification is particularly important in an uncertain market environment.

So, in addition to US stocks, investors should always consider some allocation to international equities and other asset classes, including commodities. Among developed international markets, I still like Europe and Japan. (Read: 3 European ETFs to buy after ECB Action)

As many emerging markets saw substantial gains earlier this year, their gains during the second half may be rather muted. Looking at the longer-term scenario--India ETFs like Wisdom Tree India Earnings Fund (EPI) and Mexico ETFs like iShares MSCI Mexico ETF (EWW)--look poised to benefit from reform-oriented and business-friendly governments in these countries.

Among commodities, while agricultural commodities may gain from weather related issues, they are generally more volatile and suitable for higher risk tolerant investors.

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